Extreme Networks Inc (EXTR) 2003 Q2 法說會逐字稿

Welcome to the Extreme Networks' Second Quarter Fiscal 2003 Earnings Conference Call.

At this time, all participants have been placed on a listen-only mode.

Later, we will proceed with the question-and-answer session.

At that time, if you have a question, you would need to press the numbers one, followed by four, on your telephone keypad.

As a reminder, this conference call is being recorded today, Monday, January 6, 2003.

I would now like to turn the floor over to Mr. Hal Covert, Vice President and CFO.

Please go ahead, sir.

Thank you.

Good afternoon.

On the call with me today is Gordon Stitt, President, CEO and Chairman of Extreme Networks.

Earlier this afternoon, we issued a press release announcing our financial results for Q2 FY 2003.

A copy of this release is available on our website at ExtremeNetworks.com.

A couple of reminders.

This call is being recorded and broadcast live over the Internet.

It will be posted on our website and available for replay shortly after the conclusion of the call.

Some of the remarks made during this call may include forward-looking statements, as governed by the Private Securities Reform Act of 1995.

Any statements about future events and trends, including steps we plan to take to improve our financial results or our financial condition, should be considered as forward-looking statements.

These statements – these forward-looking statements may differ from actual results and are subject to risk and uncertainties, as detailed in our filings with the SEC and in our press release today.

One other important housekeeping note.

Today's press release represents the final results for the quarter.

We do not plan to hold a conference call on January 15, as would be our typical pattern.

I would now like to turn the call over to Gordon.

Thank you, Hal.

Good afternoon, and thank you for joining our Q2 earnings call.

As indicated in our press release that went out earlier this afternoon for Q2 fiscal '03, we generated revenue of 90.2 million and had a loss of 17 cents per share, including special charges and deferred compensation.

Without the special charges and deferred compensation, we had a loss of two cents per share.

These results compared to revenue of 100.6 million and a loss of three cents per share for the previous quarter, that is Q1 of '03.

Needless to say, we're not satisfied with the marketplace or financial performance that we've achieved over the last two quarters.

Before getting to the programs that we have implemented or are implementing to improve our performance, I'd like to make two points, one regarding the market and the other regarding our value proposition.

First, we do not believe that there's been a fundamental change in our core addressed markets or competitive situation during the last several quarters.

Let me be specific here.

Over the last two years, the network equipment market has been a very difficult environment in both the enterprise and Ethernet Metro segments.

As you know, IT budgets have declined and only recently have appeared to show some degree of stabilization.

From a product standpoint, modular products have maintained average ASPs in line with historical patterns, and it appears that this trend will continue while the competitive environment for stackable products has intensified.

This is due to the introduction of new layer-3 stackable products by our competitors, as well as reclassifications of layer-2 stackable products into the layer-3 category.

Now, our large enterprise customers understand the difference between enterprise class layer 3 and products that are better suited to small or medium business.

But nonetheless, there's confusion in the customer base as more and more suppliers claimed layer-3 functionality.

Our focus on end-to-end layer-3 switching, layer-4 through -7 solutions and 10-Gigabit solutions positions us in the segments of the market that are projected to grow the fastest over the next several years.

In addition, our product mix has trended toward modular products.

Modular products are more strategic to the core of the network, and, thereby, the supplier has more [count][ph] control in the ability to deliver services.

These products have historically carried higher margins.

Looking at our competitors, we do not believe that there's been a meaningful change in our competitive position from a product offering, distribution channel, geographic or vertical market standpoint.

Perceived and/or real changes in the competitive environment are more likely the result of the timing of new product introduction cycles and operational execution.

Now, during the last year, Extreme has addressed three major transitions to strengthen our marketplace and our financial performance.

First, the realignment of our sales organization to improve the linkage between our customers and value-added channel partners.

Second, the introduction of significant enhancements and extensions for our current product family based on the third generation of our ASICs.

And consolidation and tighter control of our supply chain.

Although we've made good progress in each of these areas, our execution could have been more effective.

During 2003, we will intensify our focus on driving improved performance and pushing towards our long-term financial performance goals.

The second of my two points relates to the value proposition.

Today, we have a compelling value proposition, and we are pursuing a large and attractive market.

Key elements of our value proposition include best-of-breed and the Ethernet switching solutions, from wiring closet to network data center, best architecture and operational simplicity, availability, redundancy, scalability and security, lowest cost of ownership, both from an initial capital expenditure and ongoing operating expense, a comprehensive service offering, including 24 by 7 by 365 availability around the world, professional services and training, and the best migration path to deploy new technology and related solutions, protection of previous investment equipment, software and in human capital.

Each aspect of our value proposition can make a meaningful difference to our customers' top- and bottom-line performance now.

In the tough IT that everyone is facing today, Extreme can make a major difference in the ROI and payback for every dollar invested by our customers.

This is the message that we will continue to drive home throughout 2003.

In summary, we provide – we currently provide customers the best Ethernet layer-3 value proposition today, and we have more aggressive new product introduction plans for 2003.

I'll talk about new products in a few minutes, but before doing that, I want to make a few comments regarding our addressed market.

Our primary target markets are large enterprises, that is, companies with more than 1,000-plus network connections, and Ethernet Metro service providers.

These customers typically have large, complex and productive networks.

Key network characteristics include requirements for high availability, ability to support new applications on a broad scale, and support for new media types over an extended network.

Our value proposition excels in this environment.

In our most recent quarters, enterprise customers represented approximately 75 percent of our revenue.

Another key point with our focus on layer-3 switching, layer 4 through 7 solutions and 10-Gig, we are addressing the market segments that are projected to be the fastest growing over the next several years.

Today, we have a significant customer base of large enterprises and Ethernet Metro service providers in every major geographic area in the world.

Our installed base is now seven million layer-3 ports.

In addition, we have been recognized by Gartner Group, a leading market research organization, as a leader in completeness of vision in our ability to execute in this arena.

Finally, our addressed vertical markets include manufacturing, government, healthcare, education, media companies and financial services.

We expect several of these vertical segments to be in buying mode during 2003, particularly, the government segment.

In terms of win during the quarter, we have one significant government business that we'll be able to talk about as soon as our customer permits it.

On the media front, we won business at both the Discovery Channel and CNN.com during this quarter.

Both were new customers for Extreme.

Now, I'd like to discuss a new product.

Calendar year 2003 is going to be all about new products, and this will be the driver for our growth.

We plan to introduce major enhancements to our current product families in the first half of the year.

These enhancements will improve both the performance and functionality of our current product and solidify their competitive position over the next several years.

We plan to continue to offer a full range of layer-3, layer-4 through –7, and 10-Gig products that address network access, aggregation and core.

New functionality, such as very strong support for voice-over IP and security, will be primary considerations.

And, finally, we expect our product mix to continue to trend towards modular products.

In our most recent quarters, modular products represented approximately 60 percent of our product revenue.

As you know, we have maintained a high level of investment in R&D.

Extreme has always taken a strategic approach to product development, whereas others have taken a more tactical, short-term or opportunistic approach.

Over the years, we have introduced two full generations of ASICs, then built product lines around those.

Those product lines have had long lives.

The effective implementation of this strategy not only preserves customer investment; it allows for a leapfrog competitive strategy.

Two years ago, we began development of our third-generation ASIC chipset, code name's [Triumph][ph].

And simultaneously, we set up an independent team to develop fourth-generation technology.

We're pleased to say that our third-generation technology based on Triumph will ship in products during the first half of calendar '03, ahead of where we had indicated earlier.

This technology brings a number of benefits, including high density, new functionality, including advanced traffic shaping, hardware acceleration for additional functions, integrated support for voice-over IP, and other functional enhancements.

This new chipset is targeted primarily at our modular product lines, that is, Alpine and BlackDiamond, and we've designed this new chipset and our product to provide a seamless and nondisruptive upgrade path for existing customers.

These new products support and enhance our value proposition for both existing and new customers.

At the same time as we embarked on the Triumph project, we also began developing a revolutionary new ASIC chipset that is focused on Metro Ethernet technology.

This technology, which we will introduce late in the calendar year, is a major leap forward and we believe will deliver revenue growth for more than five years.

Products based on this fourth-generation technology will complement our current product families and primarily be focused on the very largest enterprises and the Ethernet Metro service providers.

By employing leading technology, this new product family will dramatically improve performance and functionality and continue to position Extreme as a technology leader.

Whereas Triumph and our fourth-generation technology are focused on modular products, let's spend a moment and turn our attention to stackables, which represents an important part of our business.

Bear in mind that our customers buy both modular and stackable products from us, so this business is strategic.

The stackable market has become more price competitive, with price declines accompanied by market growth.

In actuality, a layer-3 stackable market has bifurcated into two segments: first, enterprise-class products, and, second, small and medium business products.

Previously, the small and medium business segment has been the lower functionality layer-2 market.

Now, the availability of [merchant silicon][ph] has added layer-3 capability and caused market research firms to reclassify some products.

Because of the cost, customers who have purchased layer-2 products in the past now have bought layer 3.

The availability of these products, based upon merchant silicon, has caused some to compare this market to the PC market and to predict commoditization.

The difference in networking, whether it be stackables, as we were discussing, or other products, is who's the Microsoft?

And that is, where do you go for software?

Now, our customers in large enterprise and Metro Ethernet understand the difference between enterprise class and small or medium business.

It is all about software.

Software provides the running functionality, software provides the resilience of VLAN capability, all the features necessary to build a network and have it interoperate.

As I mentioned, Extreme has an installed base of more than seven million layer-3 ports all running ExtremeWare.

We have customers with some 50,000 nodes in a network, a single campus network.

We have Metro Ethernet service providers who have built up very large networks.

In fact, in the quarter just closed, we delivered to Korea Telecom a network with over 450 Alpine switches to provide their nationwide Metro service.

And at the same time, we also built out their new data center with our BlackDiamond switches.

The experience we have in building networks of this size is rare.

There are very few companies that have built this size of network.

The education we've received in building these network s has been incredibly valuable.

Over the last six years, we've worked closely with some of the largest users in the world and we've listened carefully.

This experience has led us to build some of the most robust routing protocols for enterprises, protocols that have been tested and proven in real 50,000-node environments.

We've developed unique redundancy protocols, such as ESRP for enterprises and [EAPS], our revolutionary ring protocol that enables large networks to keep running regardless of the traffic and network configuration.

The route capacity of our switches is the highest in the industry, and you can expect Triumph-based products to take this to even higher levels.

During this quarter, we introduced ExtremeWare 7.0, our next major release; 7.0 runs across all of our platforms and provides one of the most robust operating environments around.

So to summarize the product [indiscernible], 10 Gigabits is doing well.

This is a market that will build through the year and become an important part of our business.

Our third-generation Triumph technology is on track for delivery and products during the first half of this calendar year.

And you can expect solutions for critical enterprise applications, such as voice-over IP and media streaming.

And you can expect software to differentiate Extreme in the highly competitive stackable business.

During this year, 2003, we will follow our policy of announcing new products, including related pricing functionality and performance, when they are ready for first customer shipment.

Now, I'd like to turn the call over to Hal to discuss our financial performance for the quarter just closed.

Hal?

Thank you, Gordon.

In order to report our financial results for Q2 FY 2003 as fast as reasonably possible, our management team put in special effort over the holidays to enable us to release our final financial results for the quarter at this time.

Therefore, our historical pattern of releasing our financial results on the third Wednesday after the completion of a quarter will not take place this quarter.

I will now cover four topics: highlights of special charges that we recorded during the quarter; an update on the progress below our breakeven point; a detailed discussion of Q2 FY 2003 financial results; and, finally, financial guidance.

For Q2 FY 2003, we recorded special charges of $26.9 million, consisting of 9.6 million for excess real estate, 14.6 million for reducing the carrying value of fixed assets, and 2.7 million for severance expense.

From a cash utilization standpoint, the only immediate impact related to these charges is from severance expense.

The fixed asset charge will not impact cash, and the excess real estate will impact cash over a number of years.

The $9.6 million real estate charge relates to excess real estate that was first reported in Q3 FY 2002.

During that quarter, which ended on March 31, 2002, a charge of $25.4 million was recorded for excess real estate.

The commercial real estate market has continued to deteriorate since the initial charge was [taking], necessitating an increase in reserves that take the unfavorable difference between lease obligation payments and projected sublease receipts into consideration.

Three leases accounted for approximately 80 percent of the $9.6 million excess real estate charge.

These same three leases accounted for more than 90 percent of the initial $25.4 million charge.

Two of these leases are now projected not to generate any sublease receipts for 30 months, as opposed to 12 months in the initial analysis.

Subsequent to the 30 months, we have projected that we will receive $5.4 million of sublease receipts from these leases.

The remaining lease is now projected to generate lower sublease receipts over its remaining life than initially projected based on a new sublease that the Company negotiated.

During Q2 FY 2003, the Company completed a fixed asset inventory as part of our recent new ERP system implementation.

The new ERP system enables the tracking of fixed assets by cost center and responsible manager.

The fixed asset inventory resulted in the identification of $14.6 million of fixed assets that the Company will no longer carry on our balance sheet or that we have determined are impaired.

The assets that we will no longer carry on the balance sheet all have an initial individual acquisition price under $3,000.

Responsible cost center managers will continue to track these assets from a physical control standpoint.

Going forward, the new ERP system and related business practices, along with tightening payback and return on investment criteria for capital expenditures, will enhance management's capability to monitor fixed asset utilization and control capital expenditures.

As part of the goal to lower our breakeven point, the Company reduced its staff and temporary personnel by approximately 10 percent, or 100 people, during Q2 FY 2003.

A charge of $2.7 million for severance expense was recorded as part of this process.

Now, I'd like to discuss our progress towards lowering our breakeven point.

During the quarter, several key actions were taken that have resulted in decreasing expenses.

Staff and temporary personnel were reduced by 100 people.

This reduction will result in quarterly savings of approximately $2.3 million.

A reduction in ongoing capital expenditures and a fixed asset charge previously discussed have and will continue to result in lower depreciation expense.

The initial impact resulted in savings of approximately $2.2 million during quarter two FY 2003.

And, finally, continued improvement in supply chain management has and will continue to result in lower product cost.

During Q2 FY 2003, these segments were approximately $2.5 million.

Of the $2.5 million, approximately half lowered the carrying value of inventory as of the end of the quarter, and the remaining half reduced cost of goods sold during the quarter.

With a gross margin of approximately 53 to 54 percent and our cost structure as we enter Q3 FY 2003, our breakeven point is approximately $90 million of quarterly revenue.

However, in the near term, gross margin in the 53- to 54-percent range may not be achievable.

Turning to our financial results for the quarter, please note that my comments regarding expenses, operating loss and net loss do not include the special charges of 26.9 million previously discussed and deferred compensation.

For Q2 FY 2003, we incurred deferred compensation expense of 1.8 million.

In Q1 FY 2003 and Q2 FY 2002, we incurred deferred compensation expense of $2 million and $2.7 million, respectively.

There were no special charges in Q1 FY 2003 or Q2 FY 2002.

The special charges for Q2 FY 2003 and deferred compensation expense represents a loss of approximately 15 cents per share on an after-tax basis.

Revenue for Q2 FY 2003 was 90.2 million versus 100.6 million in Q1 FY 2003 and 109.1 million in Q2 FY 2002.

The Q2 FY 2003 decrease in revenue when compared to Q1 FY 2003 was primarily due to a drop-off in Japanese service provider business.

Our book-to-bill ratio was approximately one for Q2 FY 2003, and we ended the quarter with backlog that was within our normal range.

On a geographic basis, the Americas represent 46 percent of our revenue for Q2 FY 2003 versus 42 percent in Q1 FY 2003 and 34 percent in Q2 FY 2002.

Europe represented 25 percent of our revenue for Q2 FY 2003 versus 21 percent in Q1 FY 2003 and 21 percent in Q2 FY 2002.

Japan represented 17 percent of our revenue for Q2 FY 2003, versus 28 percent in Q1 FY 2003 and 35 percent in Q2 FY 2002.

And Asia, not including Japan, represented 12 percent of our revenue for Q2 FY 2003 versus 9 percent in Q1 FY 2003 and 10 percent in Q2 FY 2002.

For Q2 FY 2003, we had one customer that accounted for more than 10 percent of our revenue on an individual basis.

Tech Data, a large distributor focused on our U.S. customers, accounted for 10 percent of our revenue for the quarter.

The revenue split between enterprise and service provider segments for Q2 FY 2003 was approximately 85 percent enterprise and 15 percent service provider.

Service provider revenue was lower in Q2 FY 2003 when compared to recent quarters as a result of a reduction in revenue from Japan.

Enterprise includes government and education customers.

Our service provider customers are primarily international.

Product mix consisted of 56 percent modular and 44 percent stackable for Q2 FY 2003 versus 62 percent modular and 38 percent stackable in Q1 FY 2003 and 54 percent modular and 46 percent stackable in Q2 FY 2002.

Q2 FY 2003 gross margin was 50.2 percent, compared to 48.8 percent in Q1 FY 2003 and 52.8 percent in Q2 FY 2002.

The increase in gross margin for Q2 FY 2003 when compared to Q1 FY 2003 is primarily due to lower warranty expense offset to some degree by unfavorable changes in geographic gross margin contribution.

The decrease in gross margin for Q2 FY 2003 when compared to Q2 FY 2002 is primarily due to unfavorable changes in geographic gross margin contribution.

Looking at product pricing, while at the macro level there is always competitive pressure for specific deals, we did not experience a major change in the macro environment for modular products.

Stackable product pricing was lower than historical trends due to [its hyping] of the competitor environment for stackable products.

Operating expenses were 50.6 million in Q2 FY 2003, 54.7 million in Q1 FY 2003, and 56.3 million in Q2 FY 2002.

For Q2 FY 2003, R&D expense represented 14.9 percent of revenue; sales, marketing and service, 33.7 percent; and G&A, 7.5 percent.

Operating expenses were lower in Q2 FY 2003 when compared to Q1 FY 2003 and Q2 FY 2002 as a result of lower depreciation and staff expenses.

The operating loss for Q2 FY 2003 was 5.3 million versus 5.6 million loss for quarter one FY 2003 and a $1.3 million profit for quarter two FY 2002.

The unfavorable year-over-year comparison is due to lower revenue and lower gross margin as a percent of revenue.

Other income and expense for Q2 FY 2003 was $1 million, compared to .9 million in Q1 FY 2003 and 1.7 million in Q2 FY 2002.

The difference on a year-over-year basis is primarily the result of a drop in interest income due to a decrease in interest rates and expenses related to our convertible bonds.

The convertible bonds were issued in December 2001.

Net loss for Q2 FY 2003, not including special charges and deferred compensation, was $2.7 million, compared to a $3.1 million loss for Q1 FY 2003 and a $2 million profit for Q2 FY 2002.

Net loss per share was two cents for Q2 FY 2003, not including special charges and deferred compensation, versus a loss of three cents per share for Q1 FY 2003 and two cents earnings per share in Q2 FY 2002.

Our long-term estimated tax rate remains at approximately 35 percent.

Moving to the balance sheet, I would like to highlight several items.

First, our cash, cash equivalents and marketable securities balance on December 29, 2002 was 406 million, compared to 409 million on September 30, 2002 and 385 million on December 31, 2001.

Capital expenditures in Q2 FY 2003 were 4.6 million versus 7 million in Q1 FY 2003 and 12.2 million in Q2 FY 2002.

Accounts receivable were $22 million on December 29, 2002, which equates to a DSO of 22 days.

DSO for Q1 FY 2003 was 36 days, and DSO for Q2 FY 2002 was 45 days.

Net inventory on December 29, 2002 was $28 million, compared to $34 million we quoted on September 30, 2002 and $48 million on December 31, 2001.

Channel inventory was within targeted levels at the end of Q2 FY 2003.

Keep in mind that we recognize revenue based on sell-out for the distributors.

Therefore, the shipment and the inventory into the channel does not impact reported revenue.

Revenue related to resellers and direct sales to end users is generally recognized when we ship products to the reseller or end user.

Resellers and end users do not have inventory return privileges.

Staff, including temporary personnel, as of December 29, 2002 was 900 versus 1,003 on September 30, 2002 and 1,054 on December 31, 2001.

As of December 31, 2002, the Company had 115 million shares of common stock outstanding on a fully diluted basis.

Now, I would like to address financial guidance.

As a result of the uncertain global macroeconomic environment, in general, and, in particular, on the technology sector, we will not provide any specific financial guidance.

We believe that the current business environment is not likely to dramatically change in the near term.

Therefore, we have adjusted our operating model to take this view into consideration.

Although we are not providing any specific financial guidance, we would like to make the following comments.

We are in the process of enhancing our current product families with new products that we expect to begin shipping in the second calendar quarter of 2003 and planning for the roll-off of a new family of products in the second half of calendar 2003.

In both cases, these new products will be based on new chipsets, including advanced software functionality.

We expect that revenue growth will resume as we introduce these new products.

In addition, as the global economic environment improves and our sales productivity programs continue to progress, we expect to see a positive impact on revenue generation.

Looking at gross margin, we have and expect to continue to achieve improvements in supply chain management.

However, while modular product pricing appears to be fairly stable in terms of historical trends and will likely remain in that mode, stackable product pricing has become more competitive and will likely continue that pattern.

Going forward, the favorable impact on gross margin from supply chain management improvements may be offset by the decline in stackable products' gross margin and unfavorable geographic margin contribution levels until our new products begin shipping.

With the recent reduction in our operating expenses and capital expenditures and continued effective management of working capital, we believe that we will generate free cash flow going forward.

Finally, we believe that we have taken the operational steps necessary to achieve our long-term marketplace and financial goals as articulated earlier in the call by Gordon.

I will now turn the call back over to Gordon.

Thanks, Hal.

Before concluding, I'd like to summarize how our senior leadership team here believes that Extreme is well positioned as we move into the new calendar year.

First of all, we have a compelling value proposition for customers today and a plan that if we are executing against continue to enhance our value proposition throughout the new year with exciting new products.

We address a large market with customers that are starting to show signs of improvement in their business and a willingness to buy products that make a meaningful difference in this process.

We have enhanced our distribution channel over the past 12 months, and we'll continue to pursue this process throughout 2003.

We have made major improvements in supply chain management and will continue this process throughout the new year.

We have lowered our breakeven point while maintaining a necessary level of investment in R&D.

We've done an effective job of managing our balance sheet and expect to generate cash flow, free cash flow, moving forward.

And finally, we have a strong leadership team that was developed over the last 18 months, including the addition of our Chief Operating Officer, Alex Gray, [Diane Puitt][ph], our new VP of Operations, and Siva Ananmalay, our new Vice President of Software.

In summary, we're well positioned to pursue our three primary goals as we enter 2003, to be the best alternative in the enterprise market, to be the leader in the emerging Ethernet Metro market, and to deliver world-class shareholder value.

Our focus throughout the year will be on execution and delivering great customer and shareholder value.

Thank you for the time, and with that, I'd like to open things up for questions.

Thank you, sir.

Ladies and gentlemen, the floor is now open for questions and comments.

If you do have a question or a comment, please press the numbers one, followed by four, on your keypad.

If your question has already been asked and you would like to remove yourself from the queue, please press the pound key.

Please note, ladies and gentlemen, that due to time constraints, we do ask that you limit yourself to one question during the question-and-answer session.

Our first question of the evening comes from Christin Armacost with SG Cowen.

I notice the Americas business was up but Tech Data was down as a percent of revenue.

Can you talk about what you're doing with the channels and if you've been changing any of your distribution channels?

Yes, as you know, we started the process of approximately a year ago really refining our channel strategy in the U.S., really focusing on, you know, large system integrators, large resellers that can go out and build large-scale enterprise networks.

And, you know, what we've done is really push a lot of the – you know, the smaller deals, if you will, you know, to people who buy through a two-tier network, such as Tech Data.

Would there be anything else – well, that would suggest that Tech Data would increase as a percent of revenue, but they were down, so I’m wondering where some of the other channels that you were using, if there was any greater business done direct this quarter?

Yes, the – you know, the strategic focus is on large enterprise, and it's not surprising that Tech Data would go down a little bit, although we expect them to continue to be a 10-percent customer.

But we've made significant investments in really focusing on the largest customers, and I think in looking back on the quarter's results, we saw some benefit from that, and I'm confident we'll see that as we move forward.

The other point, Christin, is that we did have one other large U.S. distributor, and it really picked up in terms of percent.

Didn't make 10 percent this quarter, but it did pick up quite a bit over the previous quarter.

Who was that?

GE Access.

Okay, thank you.

Once again, ladies and gentlemen, as a reminder, we do ask that you limit yourself to one question.

Our next question of the evening comes from Mark Sue with Unterberg Towbin.

Hal, when you speak about – when you spoke about the unfavorable geographic margin contributions, can we assume that pricing was bad, particularly in Asia?

And speaking of Asia, what's the likely trend in Japan during the March quarter following the seasonality trends – historical seasonality trends in this region?

Thank you.

Yeah, Mark, the unfavorable impact from a gross margin standpoint was primarily from geographic mix as opposed to pricing.

As indicated, Japan dropped off, and the margins there, contribution margins, have typically been higher there than in some of the other regions.

So that was the major driver.

So pricing, as we indicated, for modular products has been fairly stable and for stackable products has been more competitive.

And also on your thoughts on what Japan might do in the March quarter, seeing that it was only 17 percent this current quarter?

Yeah, I mean fundamentally, we think that the business there is lumpy and there's been a number of major roll-offs there.

And until that picks up again, it's probably going to be relatively flat as – in line with this past quarter.

Okay, thank you.

Our next question comes from Steven Kamman with CIBC World Markets.

The low DSOs – was that due to seasonality, or was that due to the supply chain management program?

I’m just trying to figure out modeling forward.

And then can you give me any more sort of specifics on stackable pricing?

How much it was down quarter on quarter or year on year?

Yeah, the first part, Steven, on the DSOs, I went through that pretty thoroughly, and I'll tell you it was primarily due to solid collections, and it will go up next quarter.

Okay.

You know, again, we had a great collections quarter.

From a pricing standpoint, the stackable pricing, as we indicated earlier, was down, I would say, you know, at a fairly substantial higher rate than it has been in the past, and we'll have to wait and see for a couple quarters of where it stabilizes because of all the changes with reclassifications and so forth that have taken place.

But we do expect that trend to probably continue downward.

Any guess as a percentage number or --?

It's hard to guess a percentage.

Understood.

Thanks a lot.

Our next question of the evening comes from Erik Suppiger with Pacific Growth.

Can you comment if there was any resolution in terms of going back to the component supplier that you had last quarter that gave you apparently defective components?

Did you get any compensation for the damages that you incurred?

Yeah, first, a couple points, Erik.

Number one is that our warranty expense during the quarter did return to a normal level, so we were very happy to see that.

And we are going to get compensation for the defective parts that we've discussed in the past, but, again, that's going to flow in over a couple quarters, and it's not going to be a meaningful amount of money relative to the quarter performance.

Did you get any benefit this quarter from that?

No, it's going to actually start the next quarter.

And then you had mentioned that you expect to be cash flow positive in the future.

What kind of revenues does that imply?

Well, I think if you take a look at our $90-million breakeven point, our feeling is at that level we will be cash flow positive.

So you're anticipating roughly flat from here going forward or up?

Well, to answer your question, $90 million in revenue would equate to breakeven at the bottom line and from a cash flow standpoint for us.

Great.

Thank you.

Once again, ladies and gentlemen, as a reminder, we do ask that you limit yourself to one question.

Our next question of the evening comes from Alex Henderson with Salomon Smith Barney.

I'm going to break that rule just a little bit.

You didn't offer up a book-to-bill number.

I was wondering if you'd quickly give us that.

And then I had a question on, you know, the channel opportunity with other potential channel partners that you might be giving product to.

Specifically, what portion of your product line might you outsource to an unnamed potential channel partner that currently sells other types of products?

Okay, so, Alex, I'll take the first half and pass the ball to Gordon on the second half.

We said that our book-to-bill ratio was approximately one, and it actually turned out to be .9823 or somewhere in that range, so it was pretty close to one.

Great.

Hi, Alex, this is Gordon.

On your very obscure question there, I would say that, you know, as we look towards this year, we expect a greater percentage of our channel business to go through key regional resellers, many of whom we've done business with for years, and also through some of our newer-signed partners that are more national in scope.

And as we'd indicated, some of the, you know, the smaller resellers –

I'm sorry.

That's not the question that I’m trying to ask.

Let me try and rephrase it.

There is a presumption that you're going to sign up or perform an executed transaction with a large seller of a completely different type of equipment.

Without putting names on it, obviously, there's been a lot of discussion about it.

The question I’m asking is, if you were to sign a deal selling products through that other company, would that entail the entire product line?

Would it entail mainly the stackable products?

Might you also include a low-end chassis product?

And I presume that your strategy is to bifurcate your line so that any products sold by this company would not cannibalize your existing sales by being able to use your new product offerings to differentiate it.

Could you talk a little bit about how you're planning to handle that channel conflict potential?

I guess that's kind of like a third derivative, right?

A speculation on a speculation based upon a speculation.

So, you know, today our approach is that virtually all of our channel partners have access, you know, to our entire product line.

As I indicated on the call, you know, we have a significant investment in software, and you can expect to see us differentiate that in the future and perhaps have different levels of software releases that have different levels of channel qualification behind them.

So I hope that helps shed some light on your third derivative there.

I'll leave it alone.

Thanks.

Thanks, Alex.

Our next question comes from [Eni Chopak][ph] with [Nutmeg Securities][ph].

Hal, I want to ask you to comment on something, and then I have a question really.

I've noticed that you did not use a pro forma presentation for the first time.

You're the second company in this industry that I've seen in the last few weeks that's gone only to GAAP.

Would you just comment on the reason why you are doing that now?

Yeah, I think our goal is really to get our financial results out in as clear a pattern and indication as we can, and we highlighted the charges that we had for the quarter, and we think that, combined with a GAAP presentation that we issued as part of a press release, is sufficient to do that.

Oh, I agree, and I’m glad to see this happening, but I'm wondering if there were any specific influences or factors that caused you to do this at this time?

No, other than – our goal is to get a clear presentation out there.

That was it.

So the SEC draft proposal did not enter into this at all?

Oh, certainly all the activity that's going on around the SEC influences your decisions and thought process, so, but there was nothing that triggered our decision this quarter, in particular.

Gordon, specific question for you with respect to 10 Gig E. Could you just comment about how you see that market developing, how per-port pricing has changed over, say, the last six months?

How large of a market opportunity do you believe it's going to emerge into over the next year or two?

Yeah, [indiscernible] was, you know, over the holidays, I was reading some of the trade magazines, getting a little caught up, and I believe 10 Gig was listed as one of the 10 most hyped technologies of 2002 in that there was certainly a lot of speculation last year about this technology and speculation that this would be a huge market very quickly.

We've always said that we expect this would be an incremental market, that it would grow gradually and ultimately would become very important.

We've certainly seen installations of our technology in both the Metro area and in large enterprise in providing enhanced backbone capacity, and we expect the market to grow gradually.

You know, currently, the pricing is pretty high, right around the – I think most suppliers are in a – anywhere from a 50 to $70,000-per-port price on a modular blade.

You know, clearly, that's going to limit it to people who really need that technology.

I do expect that during this calendar year that that will drop substantially, but you still have to look at it from a realistic standpoint and see this as a market that's going to grow gradually and very nicely and be strategic over the next couple of years.

But I don't think it will form a huge bubble this year.

Will it be 10 percent of your revenue this year?

I think it would be – it would be hard to break that out.

If we counted the chassis itself – you know, every time – you know, some people have said 10 Gig is X percent of their revenue, and what they're doing is counting the chassis as well as the blade and counting everything involved in that, and if we did it that way, then certainly I would expect it would be 10 percent.

But if you look at just breaking out the revenue associated with 10 Gig, you know, I think that would be a stretch goal.

Okay, thanks.

Once again, ladies and gentlemen, we do ask that you limit yourself to one question.

Our next question of the evening comes from Richard Church with Wachovia Securities.

Can you just comment on linearity in the December quarter, and did you see a significant drop-off in the last couple of weeks of December?

Thank you.

Richard, when you go back and look at our results for the quarter, it was pretty much in line with the 20, 30, 50.

There were some variations, but nothing out of the ordinary range, and there was not a drop-off in the last few weeks.

Okay, thanks a lot.

Our next question comes from Gina Sockolow with Buckingham Palace.

Buckingham Securities.

Thank you.

Could you tell us what percent – why the accounts receivable declined about 18 million sequentially and whether there was any factoring in that?

And, also, your deferred revenue declined almost 26 million sequentially.

Where was – was this accounted for in the revenue?

And if so, it's about 30 percent of revenue, and could you explain that?

Thank you.

Yeah, first of all, on the A/R, there was no factoring involved.

It was a very good, solid collections month, and our A/R over 60 days or over 45 days old is really in very solid shape, so there were no issues there.

And the deferred revenue, I think, was the second part of your question?

Yes.

Yeah, there really wasn't much of a drop-off there compared to June or last quarter, so I may have to dig into that and get back to you, Gina.

I'm not sure which numbers you were looking at.

Okay.

And, lastly, you said Korea Telecom was a significant percent of revenue this quarter?

Well, we said that we'd closed a major deal with them, yes.

But it was less than 10 percent?

Yes.

Thank you.

Our next question comes from Jason Ader with Thomas Weisel.

Gordon, could you – I guess I’m a little confused on the realignment of the sales organization topic that you brought up.

Could you explain exactly what your strategy is, direct versus indirect, VARS versus distributors, direct touch?

I'm just trying to understand better, you know, how you guys are doing things today versus, say, how you were doing things a year-and-a-half ago?

Yeah, Jason, I would say to put it simply, we've moved to a direct touch model worldwide.

We allow customers to choose their method of fulfillment.

Outside the U.S., we've only worked with partners and will continue that strategy.

And within the U.S., you know, we do some small amount of business direct, you know, based upon, you know, customers' specific request, but we do most of our business through reseller partners.

What's changed is that we're much more actively involved in the deals today, so rather than, you know, relying on a partner to go out by themselves, our sales teams are really aligned to work with them directly involving the end-user.

So why not just move to direct, Gordon?

Why even have the channels?

Well, the channels bring a lot of value to us.

And, also, specifically, a lot of our customers really prefer to buy a broad range of IT components from a channel partner.

In many cases, the channel partner knows the customer very well and really provides value there.

They also provide integration services, and we've seen that more and more as the type of reseller we've dealt with changes, that they're providing high levels of service and high levels of integration that we couldn't provide directly.

So this means that the percentage of business coming through distributors in the future is going to be lower than it has been and more will go through these regional VARs, correct?

I think you'll see a higher percentage going through, you know, strong regional VARs at our highest tiers and national resellers in the U.S.

I don't think you'll see any shifts outside the U.S.

Okay, thanks.

Once again, ladies and gentlemen, we do ask that you limit yourself to one question.

Our next question comes from John Wilson with RBC Capital Markets.

I guess my question would be if you look at the distribution channel – there's been a lot of talk for that this afternoon – but a few quarters ago, there was talk that that was a major initiative for you in terms of adding major new channels and driving your focus to large enterprise, and that was going to be a driver of growth.

And there seems to be less talk about that now and more reliance on, you know, the product enhancements.

Is that, you know, fundamentally – what is going on there?

Are we just basically replacing one set of distributors with another and that really the issue here in terms of getting back to growth is that we're missing a product transition?

Or can you just lay out why all of a sudden distribution's not such an issue and the product is more of an issue relative to, say, a quarter or two ago?

Well, first of all, John, I would say that it hasn't really changed in terms of our focus on resellers.

I think it's, you know, just the commentary that we chose to discuss today on this call was more related to products than to channels.

You know, the channel transition is a long-term transition.

You don't change relationships and behavior overnight.

You know, as I mentioned, we do have a long-standing relationship with some of our regional resellers, and those folks, you know, continue to perform very well for us.

We have signed up new deals, and we're working real hard to get productivity of those new channel partners high.

You know, products are, you know, effectively independent of that effort and represent, you know, a significant investment as well.

So you don't think the fact that there are customers sort of sitting there waiting for this next generation of product and that's one of the reasons why we're sitting here watching the sequential declines in the sales revenue?

Well, I think that, you know, as we mentioned, these products, you know, enhance existing lines, and we have, you know, designed in a very smooth transition and migration for our customers.

So I don't believe that anybody is waiting for new products specifically.

They certainly shouldn't be.

But these new products, we believe, will enhance growth and will allow us to open up new segments.

All right.

Thanks.

Our next question comes from Tim Luke with Lehman Brothers.

Just revisiting that new product issue.

If you could just, Gordon, just give us your sense of what you think the key differentiators are in terms of the [trials] offering and any further color on how you expect to manage the transition from the old to the new?

Tim, let me address that in reverse order.

You know, the transition from old to new is very straightforward in that, you know, customers will be able to buy different blades for their existing systems so that, you know, the transition is actually a straightforward, one for new customers and for existing customers as well, and that's always been our strategy.

In terms of the capability, I think I touched on some of those in terms of increased port density, thereby driving down the cost per port.

Also, in terms of providing products with more over-subscription, wherein the past we really focused on a more networked core, which is a non-blocking model, and providing now some oversubscribed products that allow for higher density and, therefore, a lower port cost, which is important in some applications.

I also mentioned that there's some enhanced functionality in terms of some significant enhancements in the traffic shaping, rate shaping, which is pretty important for some of our carrier customers, as well as some increased functionality, such as support for voice-over IP and some enhanced security capabilities.

And this would ship prior to intro by [indiscernible] date?

Well, we haven't nailed down a date as there's still some fluidity of the schedule, but we believe at this point we will deliver new products based upon our Triumph chipset during the first half of calendar '03.

And the Metro chip the fourth quarter?

Yes.

Okay, thank you.

Once again, ladies and gentlemen, as a reminder, we do ask that you limit yourself to one question.

Our next question comes from [E.

Hugh Chelbloom][ph] with JP Morgan.

Comparing the revenue split geographically this quarter to last quarter, it seems that most of the regions were pretty much stable, obviously with the exception of Japan.

And the weakness you quoted was in stackables, and in the last kind of pieces that Japan is primarily service providers.

Is the assumption correct, therefore, that Japan primarily and most of your international business is all stackable business and --?

No, our stackable business actually went up a little bit this quarter.

It was 56 – or, I should say, it went down a little bit, [5644] versus [6238] last quarter.

Right.

So, fundamentally, the drop-off that we've seen in this quarter was from Japan, and it was primarily on the service provider side.

Independent of product.

Yeah, independent of product.

Can you break down the revenue loss from Japan?

Is it mainly modular then?

It falls along the, you know, roughly 60/40 characteristics of our overall product distribution, roughly 60 percent modular and 40 percent stackable.

Okay.

And Japan did drop from 28 percent down to 17 percent of our revenue, so.

Right.

And that seems to be pretty much the entire 10-, $11-million-dollar drop from one quarter –

Yeah, that was it.

-- to the next.

But if in that 10-, $11- million drop, 40 percent of that drop was stackable, 60 percent was modular, and yet the stackable mix changed a little bit, I’m just wondering, are you actually shipping, in fact, more volume of stackable to make up for the fact that it sounds like there's increased pricing pressure there, yet it didn't change that much?

Does that kind of make sense?

Yeah, you know, the mix of stackable versus modular has been relatively consistent over the last four quarters.

I mean it bounces around a couple percentage points each quarter –

Right.

-- but, you know, not in a material amount, and nothing really changed this quarter.

You know, each of the regions, you know, buys products in roughly those percentage, so a drop-off in one region, and in this particular case, you know, didn't cause a change in product mix.

Right.

But I would imagine if you're pricing declined noticeably in stackables whereas it did not in modular, it would almost imply, if I'm doing the math right, that your volume went up in stackables to keep the mix roughly the same.

Unit volume.

Yeah, unit volume, yes.

Yes, that's correct.

Yes, certainly.

Okay.

And then, last, just to follow-up on that, do you have a sense of splitting your revenues by cards versus chassis in the modular world?

No, we haven't done that, haven't reported that anyway.

Okay, thank you.

Once again, we do ask that you limit yourself to one question.

Our next question comes from Reg King with WR Hembrecht.

Gordon, can you comment a little bit on – I believe that one of the strategic partners that you announced in the August timeframe has indicated it has plans to introduce some products which appear to be competitive, to me.

Can you comment on your management of that relationship?

Are you working with them on this, or you are going to actually take a different tack and not work with that partner?

Or how will you manage their relationship going forward?

I'm sorry, could you be more specific as to [inaudible]?

I'm speaking of Dell.

Okay.

Yeah, I mean as we've mentioned, you know, Dell has been a reseller of ours for some time, and, you know, we haven't made any other announcements beyond that.

So, you know, certainly they have – they've introduced networking products as you know and have made commitments to introduce a broader product line.

And, you know, we see what they're doing as pretty complementary to our large enterprise solutions.

So will you work them?

Will they be shipping your products as a part of this program of introducing layer-3 switching?

Well, they do re-sell our products today so –

Right.

-- you know, they go out into their customers and they sell some of their stackable products alongside our chassis, and that's been the nature of our reseller agreement with them.

Okay, so you see the relationship continuing on as they move up the food chain?

Yes, certainly.

Okay.

Thank you.

Our next question comes from Tad LaFountain with Needham.

Yes, if we look at these chipsets that are being developed, does any of this involve an enhancement to the switch fabric so that a fully configured 10-Gig system would be non-blocking?

In – I'm sorry, Tad, in terms of some of the merchant silicon?

Is that what you're asking?

Well, in your own internal, or whether you access it from the outside, is there an ability to enhance the back plane so that the switch fabric can handle a fully configured 10-Gig system?

Okay, so, you know, our current 10-Gig products, as everybody's in the market today, or at least all the leading suppliers, you know, has 8 Gig to each slot.

I think that's what you're referring to.

Right.

Where, you know, our current BlackDiamond chassis, for instance, has 8 Gigs per slot.

And so when you put a 10-Gig link in, it runs at, you know, 80 percent capacity.

So, you know, yes, that's the way it works today, as does Cisco's and others'.

And we don't plan to change our existing chassis to support higher per-slot bandwidth, but we certainly do anticipate introducing new chassis over time that do provide, you know, full-bandwidth 10-Gig.

And is that part and parcel of the two ASIC generations that you've identified?

Would that be complementary to that?

Or is this on a different schedule?

I think it's safe to say that, you know, that would be included in technology that will be delivered this year.

Great, thanks.

Thanks, Tad.

Our next question comes from Ted Jackson with U.S. Bancorp.

Yeah, I've got 10 questions.

Go ahead, Ted!

My questions have basically all been answered, but I guess one question as it relates to stackable.

It's been a pretty competitive environment on an ASP basis most of the year, and I’m sure with the increase to competition and the pricing in there that you must be looking at some ways to cost-reduce those products.

Is that a fair assumption?

And kind of what are you looking at in terms of, you know, bringing the cost to manufacture those products down to be more competitive?

Yes, we've certainly been doing that.

We've moved production of some of our products, you know, from the U.S. to overseas, and, you know, that is reducing our costs.

And we continue to look at new ways as our volumes increase on some of the stackable products, you know, to just bring lower costs of manufacturing to bear.

You know, some of that may require design changes, some of it may require supplier changes, but we're absolutely committed to doing that.

And is there any kind of schedule in place, I mean in terms of kind of where you are and where you want to be and kind of, you know, when we could see perhaps some impact on that?

We're – you know, the process is a continuous process.

You know, our 48si, which is, you know, one of our most popular stackable products, we moved to Asia manufacturer, oh, I guess about four, five, six months ago, and that's been ramping there nicely.

You know, we'll move some other products as well.

I think you should look at that as an area of continuous improvement for us and one which we'll continue to invest in.

Okay, thank you.

Our next question comes from Victor Valdivia with Hudson River Analytics.

Can you talk a little bit more about the net impact of your new products on revenues over the next four quarters?

Well, Victor, I think that's a little too tough to call at this point.

You know, we haven't announced any pricing or particular products.

We would certainly, you know, look to the products that we plan to introduce in this first half to generate a lot of customer excitement and, you know, to build revenue, particularly as we move into the second half of the year.

You know, we're pretty excited.

We think we've made the right investments over the last couple of years and that those will pay off for us.

Would you expect them to have a meaningful contribution, let's say, around 10 percent for the year?

Or is that also too early to tell?

Oh, I think it's too early to tell.

Okay, great.

Thanks.

Ladies and gentlemen, we have time for one final question.

Our final question of the evening comes from Eric Suppiger with Pacific Growth.

Quick question.

Your Japanese operations – have you had much turnover?

Or can you give us any explanation other than just the market why those would've been hit so hard?

Yeah, Erik, you know, that business has been largely centered on carriers, and we had some – seen some slowdown in deployment by those carriers, you know, over the last – over the last quarter.

You know, the business has always been, you know, pretty lumpy, but it's been balanced across the carriers and during this, you know, particular quarter, we've seen a slowdown in deployments.

So that's really the reason for the fall-off in Japan.

No turnover within your organization?

Turnover in terms of personnel?

Is that what you're talking about?

I'm sorry, I'm not sure I'm understanding your question.

I'm just wondering if you've had any employees leaving, any meaningful volumes of employees leaving?

Not meaningful, but, you know, once again, you know, that has been a heavily carrier-centric, that business for us.

We have, as you know, a number of very large customers there, and some of those customers have slowed deployments, and that's had an impact on us.

Okay, thank you.

I'd like to turn the floor back over to management for any closing comments.

No, just thanks for your participation today.

Ladies and gentlemen, we thank you for your participation in today's audio teleconference.

You may disconnect your lines at this time, and have a pleasant evening.